82 3 Reduction of External Funding Needs
The Standardised Approach is straightforward to use and does not require insti-
tutions to provide their own estimates of risks, because it permits the use of exter-
nal ratings of rating agencies and export credit agencies. It also permits the recog-
nition of a wide range of risk mitigants such as collateral and guarantees.
The Internal Ratings Based (IRB) Approach allows institutions to provide their
own risk inputs (such as probability of default and loss estimates) in the calcula-
tion of capital requirements.^226
Operational risk. Operational risk is the risk that financial institutions suffer
losses due to problems with their systems or processes, or due to human error, or
as a result of external events. Three methods of calculating the capital require-
ments for such risks are available. They include the very simple method based on
a percentage of total gross income, an intermediate approach which requires ac-
tivities to be ascribed to eight different business lines, and an advanced approach
which relies on institutions’ own calculations of operational risk.^227
Certain investment firms are permitted to continue to use the “expenditure-
based capital requirement” instead of the specific operational risk requirement.
This applies to investment firms which do not, as a central activity, undertake the
activities of dealing in securities on their own account or underwriting the issue of
securities.
Market risk. Market risk is the risk of losses because the market value of a fi-
nancial institution’s assets, liabilities and off-balance sheet items varies with
changes in market conditions. Market risk includes interest rate risk, currency risk
and equity market risk.
(^226) See paragraph 444 of the Basel II Accord. See also BIS, Basel Committee on Banking
Supervision, Principles for sound stress testing practices and supervision (May 2009).
(^227) Paragraph 645 of the Basel II Accord.